Weekly Update: Where are we in the business cycle?

01-06-2017

Happy New Year from (relatively) balmy Houston. Everyone here wanted to discuss inflation concerns, but doubts about the fully employed economy also cropped up several times. “Do you really believe 4.6% unemployment? And what about poor labor force participation?” Here and in my recent travels there were serious concerns about artificial intelligence taking over jobs, and the workforce’s unwillingness to take the sorts of jobs that are open. Then again, the median wage for most of the top 10 job categories projected to have the most openings through 2024 is relatively sobering and hardly suggestive of a wage-price spiral in the offing. Health aides, restaurant, retail and customer service work dominate the list. A frustrating aspect of the Obama recovery, now on the verge of overtaking the Reagan era as the third-longest in post-war America, has been sluggish wage growth—average hourly earnings rose 2.9% year-over-year (y/y) in this morning’s December jobs report (more below), a cycle high but still below the norm and the 4% level that typically pressures corporate earnings. “Routine" jobs that historically have paid well and require workers to perform a relatively narrow set of repeated tasks are disappearing, forcing displaced workers to either exit the workforce or take positions that pay less, according to a new study by a trio of economists from universities in California, England and Canada. The share of American workers holding such jobs dropped to 31.2% in 2014 from 40.5% in 1979, their report found. Despite subpar wage growth, unit labor costs are accelerating at their fastest pace since the 1970s. How can this be? Weak and slowing productivity growth. Unable to pass on their higher costs to customers and either unwilling or unable to invest in capital expenditures (capex) because of a subpar and uncertain recovery, businesses have turned to wage restraint. Low productivity growth and high labor costs are two key signs of a business cycle in its late stages.

Indeed, the question of the day is, where are we in the business cycle? While the evidence suggests it’s late, the Republican sweep is expected to result in aggressive fiscal stimulus, goosing growth and extending the cycle at least a few years more. Optimism among U.S. money managers and business people is as high as the Institutional Strategist has seen it the past 30 years. Prospects for tax cuts and particularly regulatory relief have executives and small businesses all ginned up, fueling a potential new willingness to invest in more people, equipment, R&D etc. As one Houston advisor put it, with Trumponomics on the way, we could get back to a boom-and-bust cycle that revives animal spirits. This of course is what the Fed has tried for years to eliminate—any type of economic cycle. Instead, policymakers put the U.S. on a credit cycle, and it will be interesting to see how a new Fed behaves when the economy runs out of steam. Minutes from its December meeting, where it raised the target funds rate and indicated potentially three moves this year, reflect a more hawkish bent, although it’s worth noting there are more doves among the voting members of this year’s policy-setting committee. Corporate tax reform could lead to a secular increase in capex that could address long-term productivity worries. The only downside for 2017 is businesses may wait a year for a possible "expense" provision that allows for the immediate and full deduction of capital investments. That won’t likely take effect until 2018. It doesn’t much matter to the market if expected tax cuts are retroactive, only that they are adopted sometime in the next 12 months.

Across Wall Street, analysts have been upwardly revising growth and profit forecasts, with the latest consensus estimate for 2017 S&P 500 earnings per share (EPS) at $132.67, implying a growth rate north of 12%. This helped drive the strong post-election rally that sent the major indexes to new highs before a slight end-of-year dip. Renaissance Macro finds little fault with the tape in 2016’s final two weeks and says the majority of its market factors favor an intermediate bullish bias, as does the upturn’s wide breadth—more than 80% of S&P issues are back above their 50-day moving average. Still, the percentage of bulls vs. bears has been above 60 six straight weeks in the Investor Intelligence poll, signaling a broad market top may be forming. Back in Houston, advisors at a happy-hour meeting were in a good mood. One gentleman who told a few off-color jokes that required curse words asked us ladies in advance if we would be offended. We said no, and laughed and laughed. It brought to mind a recent story I read about a study published by the journal Social Psychological and Personality Science that found people who liked and used swear words most often were least likely to lie. Co-author David Stillwell, from the University of Cambridge, said the simple explanation is “people who use the language that comes to mind first are less likely to be playing games with the truth.’’ My last evening in Houston was a dinner with a raucous group who thought my bullish view was not bullish enough. A seasoned advisor/gun owner, who has a sign outside his rural home warning would-be intruders, “I don’t call 911,” believes the U.S. is on the cusp of “great prosperity,” suggesting that the corporate tax rate is going to 18% and S&P EPS is heading to $150 soon. I’m bullish but thinking we are in the back half of this long recovery, Trump notwithstanding.

Positives

Manufacturing finishes strong The ISM index closed out 2016 at a 2-year high in December, led by very robust production and new orders readings that topped 60. Markit’s separate U.S. gauge also rose to near a 2-year high, while the global PMI jumped to nearly a 3-year high. Notably, new orders outpaced inventories in a whopping 85% of countries surveyed and most of the world’s largest economies reported new highs in their PMIs. The reports—and another increase in construction spending, led by single-family homes—suggest near-term acceleration.

Services does too The ISM index for December matched November for the highest reading of 2016, with new orders jumping to their highest level since mid-2015 and business activity also coming in at a very robust reading above 60. Regionally, ISM’s take on New York services activity hit a 14-month high, with the 6-month outlook surging the second-most since March 2009 on expectations for business friendly policies under Trump. Markit’s U.S. gauge remained near 1-year highs, with confidence and hiring particularly strong.

Santa visited a lot of showrooms U.S. auto sales ended 2016 on a robust note, coming in at 18.4 million annualized units, well above the consensus 17.7 million forecast and a new cycle high. While increased incentives may have helped drive the spurt, auto sales are the first good reading on consumer spending in December and these sales volumes point to a healthy and confident household sector and an economy with momentum.

Negatives

Labor market suggests late cycle Nonfarm payrolls rose a below-consensus 156K in December and, while the prior two months were revised up, monthly job growth for all of 2016 averaged 174K, down from 2015’s 209K. ADP private payrolls also rose a less-than-expected 153K, with small businesses only up 18K. Slowing y/y job growth rates are typical in a maturing cycle and also were evident in online ads, where the number of unemployed per online job opening is at mid-2007 lows.

Higher mortgage rates a headwind They’ve shot up three-quarters of a point over the past 3 months, the equivalent to roughly a 10% increase in mortgage payments on the average U.S. house. The last 2 times mortgage rates rose a lot during this expansion (2013 and 2015), home sales fell sharply. There already are signs of slowdown as mortgage purchase applications plunged the final 2 weeks of the year, pushing the y/y rate of change into negative territory (-1%) for the first time for all of 2016.

Inflation was a discussion in all my Houston meetings With oil prices nearly double their Feb. 11, 2016 bottom of $26, headline inflation measures are rising and are likely to exceed 2%. But core measures (ex food and energy) remain relatively stable and longer-term inflation expectations are still anchored. Inflation’s current acceleration is likely being felt on the health-care front: The U.S. Department of Health and Human Services reports that health-care premiums are rising by an average of 25% this year in the 38 states it surveyed, triple last year’s increases. It said insurers continue to drop out of the exchanges and remaining companies are struggling to cover costs.

What Else

Multiple(s) perspectives The “average” trailing S&P P/E ranges from the 50-year average of 16.1 times to the 20-year average of 19.5, suggesting the current trailing P/E of 21.3 makes for an “overvalued’’ market. But from an historical perspective, Dudack Research notes the trailing P/E was 29.7 in June 1999 and 26.6 in September 2009, indicating the current market may be fully valued but not overvalued related to levels seen at significant tops. Most importantly, it notes the absolute level of earnings troughed in mid-2016 and are now trending higher.

Let’s hope history repeats itself First-quarter returns usually skew to the upside when January starts on a positive trend. Also, the S&P has been down the past three Januarys and never had been down four in a row. After the last three straight down Januarys, January returns in 1958, 1971 and 2011 were 3.4%, 4% and 2.2%, respectively.

Let’s hope history doesn’t repeat itself In four of the last six tightening cycles, the Fed moved when the gap between the 10-year Treasury yield and the federal funds target rate was close to 400 basis points. At the time of the December 2016 hike, that spread was around 190 basis points. The 2 times spreads were 180 basis points or less when the Fed tightened were April 1987 and June 1999—GULP!